How to Form and Operate a Private Foundation

HOW TO FORM AND OPERATE A PRIVATE FOUNDATION

Private foundations are essentially 501(c)(3) nonprofit corporations with a small set of donors. There are many reasons you may want to form one: maybe your family wants to put assets into a tax-advantaged entity and spend funds for charitable ends or maybe you want to start a nonprofit and fund it yourself or with a small group of friends. However, private foundations are also subject to strict tax rules. This article describes the basics of establishing and operating a private foundation.

Steps to Form a Private Foundation

  • Choose a corporate name and determine availability.  Reserve the name and/or trademark the name, if appropriate and desired.
  • Prepare and file articles of incorporation with the Secretary of State. Be sure to include the required provisions for a private foundation.
    • Sample articles of incorporation can be found at the IRS website here.
    • The additional required private foundation provisions can be found here.
  • Draft foundation bylaws and a conflict of interest policy consistent with your intended management of the foundation and in compliance with local state law.
  • Set up a corporate records book (“a minutes book”).
  • Draft an action of incorporator to appoint the initial corporate directors and adopt the bylaws.
    • Sample action of incorporator is here.
  • Hold the first meeting of directors, elect officers, determine the principal office, establish accounting year and take other appropriate board actions.
  • Apply on-line and obtain a federal Employer Identification Number (FEIN).
    • Apply on-line with the IRS here.
  • Set up a corporate bank account.
  • Complete any initial filings required by the local Secretary of State.
    • For California, the initial SI-100 can be filed on-line here.
  • Ensure registration with the Attorney General of the state of incorporation and any other state where the foundation will conduct operations.
    • For California, the initial registration form is here.
  • File for tax exempt status with the IRS using Form 1023 or 1023-EZ.
    • Form 1023 and instructions for 501(c)(3) organizations here.
    • Form 1023-ez instructions here.
  • File for tax exempt status with state authorities, if appliable. California Franchise Tax Board using Form 3500 or 3500A.
  • Establish procedures to make required periodic filings with the Internal Revenue Service, the state tax authorities, the state Attorney General, and the relevant Secretary of State.
  • Establish board policy and train board members on operational requirements for a private foundation (see below).

Operating a Private Foundation

Before even contemplating operating a private foundation, you should recognize the basics of the rules that govern them. Here are some of the most important issues that could make or break your foundation:

  • Tax on Net Investment Income: Although the income of a private foundation is generally exempt, it still must pay an excise tax of 2% on its net investment income (lowered to 1% in certain cases).
  • Prohibited Activities: A private foundation will be hit with heavy excise taxes and may have its exempt status revoked if it engages in any of the following activities:
    • Legislative activities.
    • Political campaign activities.
    • Grant-making to individuals UNLESS the grant program meets certain regulatory criteria.
    • Grant-making to entities other than public charities UNLESS the grant program meets certain regulatory criteria.
    • Payments for non-charitable activities UNLESS subject to an exception.
  • Generally Ineligible for Grants from Private Foundations: Because of the above rule prohibiting foundations from making grants to other private foundations unless burdensome regulatory requirements are met, most private foundations will find themselves ineligible for grants from other foundations, sometimes rendering their funding model dead in the water.
  • Major Restrictions on Financial Transactions between the Foundation and its Directors, Officers and Substantial Donors: Tax rules strictly prohibit certain financial transactions between a foundation and its insiders. There are exceptions that soften these rules somewhat but a private foundation should adopt a general policy against any financial transactions with its directors, officers, substantial donors and other insiders. These include prohibitions on:
    • Sale, lease, or exchange of property,
    • Loans or extensions of credit;
    • Furnishing of goods, services and facilities,
    • Payment of compensation and reimbursement of expenses unless for personal services reasonable and necessary to carrying out the purposes of the foundation and the compensation or reimbursements are reasonable in amount; and
    • Transfer or use of foundation income or assets.
  • Foundation Must Spend Money on Charitable Purposes Every Year: Private foundations are generally required to spend a certain amount of money every year on charitable purposes. The formula to determine the exact amount is complicated and should be left to an accountant. It is 5% of the excess of the aggregate fair market value of all assets of the foundation (other than those used directly in carrying out the foundation’s exempt purposes) over the acquisition indebtedness with respect to such assets, reduced by certain taxes.
  • Annual Complicated Tax Filing That Must Be Made Public: Private foundations, even very small ones with annual gross receipts of less than $50,000, must file the 990-PF annually along with all applicable schedules. In addition, the foundation will need to make the 990-PF, along with its original exemption application, public for at least three years.
  • Need to Hire a Competent Accountant: See the last two bullets above.
  • Can’t Hold Family Business in the Foundation: Private foundations are prohibited from owning more than 20%, along with its insiders, in an active business enterprise. Certain exceptions apply, such as for functionally related businesses or businesses that receive 95% of gross income from passive sources. In addition, the allowed percentage is raised to 35% for businesses owned by unrelated parties.
  • Must Make Prudent Investments with Foundation Funds: The IRS imposes excise taxes on a foundation and its managers if the foundation engages in risky investments, with the exception of “program related investments” (PRIs). To qualify as a PRI, the main goal of the investment must be to further the charitable purpose of the foundation.

Founders, directors and managers of a new foundation should be intimately aware of these rules and follow up if they believe that the foundation may not be in compliance. If these rules seem too onerous to keep track of, you may want to consider an alternative to a private foundation.

Some Alternatives to a Private Foundation

  • Direct giving to charity: You can give funds directly to charities of your choice for specific programs. You can even higher a philanthropy consultant if you need assistance in determining where your dollars might have the most impact.
  • Donor advised fund (DAF): With a DAF, you would donate funds or assets to an existing nonprofit 501(c)(3), take a current charitable deduction, and advise the nonprofit on how to spend or invest the funds.
  • Engage in charitable activities with your own funds but without 501(c)(3) status: You do not need to have 501(c)(3) status to do good in the world! You can establish a nonprofit corporation and decide not to seek tax-exemption to avoid dealing with the 501(c)(3) rules. Or you can establish a limited liability company or other entity and run your charitable programs through a for-profit. Many expenses may qualify for a business deduction.
  • Seek fiscal sponsorship: If you want to directly carry out charitable programs, but are concerned about private foundation rules and do not anticipate a large number of donors, you may consider fiscal sponsorship of your activities by a 501(c)(3) public charity. You would donate funds to the charity and the charity would agree to take you on as a volunteer or employee to conduct activities.

Written by Cameron Holland.